Using and Misusing the Marital Deduction

The marital deduction is key to most estate plans of married couples. It can wipe out the entire estate tax liability. But misuse of the marital deduction can create a larger long-term tax bill or cause non-tax problems.

How To Use The Marital Deduction (And Avoid Misusing It)

The estate tax is based on the value of assets owned by the estate. Before the tax is computed, a deduction is taken for the value of all assets left to the surviving spouse. A married person can use the marital deduction to control the amount of tax his or her estate will pay. Even the entire estate can be protected from tax by leaving it to the surviving spouse.

Too much use of the marital deduction, however, might be a bad idea.

Overusing Marital Deduction may attract larger long-term tax

The marital deduction only defers taxes. The surviving spouse receives title to all property that qualifies for the deduction. He or she has to do all the tax planning to ensure that the assets get to the next generation at the lowest possible tax cost.

The surviving spouse has to do the planning without the benefit of the first spouse’s lifetime estate tax exemption equivalent, which is worth $1.5 million in 2005. The first spouse could have protected up to that much in assets from tax by leaving it to a person or a trust other than the surviving spouse. The couple together could have protected up to $3 million. But the surviving spouse alone can protect only $1.5 million with his or her own exemption.

Full use of the marital deduction is not a problem if the total estate of the couple is $1.5 million or less. For other couples, not using the lifetime estate exemption of each spouse could result in unnecessary taxes.

Non-Tax Reasons to Not Overuse Marital Deduction

There also are non-tax reasons not to make full use of the marital deduction. For example, the surviving spouse might not be able to manage the entire estate.

In addition, the first spouse loses control over who ultimately inherits the property. The property could end up with the spouse or children of a second marriage, a charity, or others who were not ultimate objects of affection of the first spouse.

A classic way to deal with all these problems is the QTIP trust, formally known as the qualified terminal interest property trust.

Wealth that might have been left to your spouse outright is transferred to the QTIP trust. A properly drafted QTIP trust qualifies for the marital deduction. One requirement is that the surviving spouse is paid all income from the trust at least annually. The estate executor also has to elect to treat the trust as a QTIP when filing the estate tax return.

When the second spouse passes away, the remaining value of the trust is included in the estate of the that spouse, just as if the property had been left to the spouse outright. But that spouse cannot designate the next beneficiaries of the trust. The spouse who created the QTIP trust determines who eventually gets the property.

The trust can provide that the surviving spouse will get more than the annual income. For example, the trust can provide that the trustee can maintain the spouse’s standard of living by distributing principal for housing, food, medical care, education, or other needs specified in the trust document. Of course, the potential disadvantage is that there might not be much left in the trust. To ensure that the trust assets end up with the objects of your affection, you might want to narrowly define the circumstances under which more than the income can be distributed and ensure your spouse has enough assets in addition to the trust to cover living expenses.

Classic Use of Marital Deduction Trust (combined with several other strategies)

Max Profits has a wife, Rosie, several children, and a $5 million estate. In his will, Max leaves to a trust for the benefit of his children an amount equal to the lifetime estate tax exemption equivalent, which is $1.5 million in 2005. This is known as a credit shelter trust. He leaves Rosie $500,000 outright. The rest of the estate is in a QTIP trust for Rosie’s benefit.

The result is that there are no estate taxes on Max’s estate. The Profits’ children receive $1.5 million from Max’s estate and the balance of the QTIP trust after Rosie passes away. Rosie’s lifetime needs should be met by the $500,000 plus the QTIP trust and perhaps income from the credit shelter trust.

A QTIP trust can add much needed flexibility to an estate.

Under the 2001 tax law, the amount that is exempt from estate taxes increases every few years. Some estate planners suggest re-writing your will every couple of years as the exempt amount changes. A better strategy is to give your executor some flexibility.

The traditional will creates a credit shelter trust that is equal to the estate tax exempt amount. The 2001 law makes that a problem. As the exempt amount increases, it could take a majority or even all the estate. That wouldn’t leave much for the surviving spouse.

One alternative is to give the executor discretion to decide how much goes into the QTIP trust, and provide that the rest goes into the credit shelter trust. The executor has up to 15 months to make the decision. The executor can consider the needs and health of the surviving spouse, the current exempt amount, and scheduled changes in the exemption. Then, the executor decides how much to put in the QTIP trust and how much goes into the credit shelter trust. This approach is more flexible than rewriting the will every couple of years.

A QTIP trust should be considered when at least one spouse has children from a previous marriage; when there is a concern that the surviving spouse might remarry and leave property to the new family; or there is a concern that the surviving spouse might not leave property to those the first spouse ultimately wants to have it.

The QTIP trust must be written by an experienced estate planner. A stray word or phrase in the document could void the marital deduction. In addition, it is very difficult to combine a QTIP trust with an IRA. Other assets should be used to fund the trust.

The marital deduction and QTIP trust are key estate planning tools for married couples. Your plan’s goals will be easier to reach if you understand the limits and the flexibility of these tools.

Called “America’s #1 Retirement Expert,” Bob Carlson’s retirement planning advice spans from tax and estate planning strategies to IRA, Social Security, medical care and investment strategies. His advice has helped tens of thousands of people for more than a decade.

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